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Fiscal Volatility Shocks and Economic Activity Jesús Fernández-Villaverde, Pablo Guerrón Quintana, Keith Kuester, Juan Rubio Ramírez University of Pennsylvania March 2, 2016 FV-G-K-R Fiscal Volatility 1 / 45 Motivation: policymakers’ travails I From 2010 to 2013, many policymakers and observers saw the U.S. economy as buffeted by larger-than-usual uncertainty about fiscal policy. I There was little consensus among policymakers about the fiscal mix and timing going forward. Ben Bernanke [July 18, 2012]: “The recovery in the United States continues to be held back by a number of other headwinds, including still-tight borrowing conditions for some businesses and households, and – as I will discuss in more detail shortly – the restraining effects of fiscal policy and fiscal uncertainty.” FV-G-K-R Fiscal Volatility 2 / 45 Motivation: electoral history I 8 patterns of party control at the Federal level (combination of President-Senate-House). I The 6 elections between 2004 and 2014 have produced 5 out of these 8 patterns. I Tie with 1878-1896 and 1910-1920 for the highest electoral instability in U.S. history. I Ideological indexes suggest that the electoral instability of 1878-1896 and 1910-1920 had less severe consequences than electoral instability now. FV-G-K-R Fiscal Volatility 3 / 45 Ideological position of members of Congress (DW-Nominate) FV-G-K-R Fiscal Volatility 4 / 45 Objective I Quantify the effects of fiscal volatility shocks on economic activity. I We estimate tax and spending processes for the U.S. with time-variant volatility using a Particle filter and a McMc. I We feed the estimated rules into an estimated equilibrium business cycle model of the U.S. economy. I We simulate the equilibrium using a third-order perturbation (new formulae for analytic non-linear IRFs). FV-G-K-R Fiscal Volatility 5 / 45 Main results I 1. We find a considerable amount of time-varying volatility in all four fiscal instruments. 2. After a fiscal volatility shock, output, consumption, hours, and investment drop on impact and stay low for several quarters. Main transmission mechanism: an endogenous increase in mark-ups. Upward pricing bias due to the shape of the profit function. 3. Fiscal volatility shocks are “stagflationary": inflation goes up while output falls. 4. We estimate a CEE-style VAR and an ACEL-style VAR to document that, after a fiscal volatility shock, markups significantly increase. FV-G-K-R Fiscal Volatility 6 / 45 Why the “stagflation”? I Steady-state profits: Pj /P 1− y − mc Pj /P − y Period profits 0.05 0 −0.05 11 21 41 −0.1 −0.15 −0.2 0.95 1 1.05 relative price (Pj /P) FV-G-K-R Fiscal Volatility 7 / 45 Main results II 5. A two-standard deviations fiscal volatility shock has an effect similar to a 30 b.p. innovation in the FFR as estimated by a SVAR. 6. At the ZLB, the effects are much bigger: 1.7 percent fall of output if we are at the ZLB for 8 quarters. 7. Most important channel: larger uncertainty about the future tax rate on capital income. 8. An accommodative monetary policy increases the effect of fiscal volatility shocks. FV-G-K-R Fiscal Volatility 8 / 45 How do we quantify fiscal volatility shocks? I Volatility is not directly observed. I No data (surveys, asset prices...) or very limited (SPF for g, but short horizon (5qtrs)). I Instead, we estimate a stochastic volatility process as in Fernández-Villaverde et al. (2011). FV-G-K-R Fiscal Volatility 9 / 45 Empirical model I Fiscal instruments follow: xt = ρx xt−1 + φx,y ỹt−1 + φx,b bt−1 yt−1 + exp(σx,t )εx,t (1/2) σx,t = (1 − ρσx ) σx + ρσx σx,t−1 + 1 − ρ2σx ηx ux,t I x ∈ {g, τc , τl , τk }. I Fiscal shocks: εx,t . I Volatility shock: ux,t . I No direct effect on taxes. FV-G-K-R Fiscal Volatility 10 / 45 Data I Construct aggregate (average) effective tax rates from NIPA (Mendoza et al., 1994; Leeper et al., 2010): consumption, labor and capital income taxes. I General government (= federal + state + local). I Spending rule: ratio of government expenditures to GDP. I Federal debt (held by the public) from St. Louis Fed. I Data sample: 1970Q1 - 2010Q2. FV-G-K-R Fiscal Volatility 11 / 45 Estimation of fiscal rules I Instrument by instrument (easily extended). I No correlation of shocks (easily extended). I Particle filter+Bayesian methods. I Flat priors. I 20,000 draws from posterior (5,000 additional burn-in draws) using McMc. I 10,000 particles to perform the evaluation of the likelihood. Estimated Parameters FV-G-K-R Fiscal Volatility 12 / 45 Smoothed volatility: tax on capital income FV-G-K-R Fiscal Volatility 13 / 45 An age of uncertainty: 1973-1975, I The Washington Post [September 16, 1973]: “Is the Nixon administration inclined to favor a tax increase? The authoritative answer last week was: (1) Yes; (2) No; (3) Maybe; (4) It is under consideration." I Watergate scandal. I George Shultz resigns on May 8, 1974, substituted by William E. Simon. I Richard Nixon resigns on August 9, 1974. I Evidence from Arthur Burns’ diary. FV-G-K-R Fiscal Volatility 14 / 45 An age of uncertainty: 1973-1975, II The New York Times [January 15, 1975]: “President Ford has not turned the economy around with his new energy and economic proposals, but at least he has turned himself around." I Gerald Ford becomes president: Nixon’s pardon erodes his credibility. I Constant fights between Nelson Rockefeller, Donald Rumsfeld, and Dick Cheney. I Tax increase announced on October 8, 1974. I After ferocious infighting within the administration, a tax reduction announced on January 16, 1975. I Continuous changes in Congress. Ford close to veto final tax cut. FV-G-K-R Fiscal Volatility 15 / 45 An age of uncertainty: 1973-1975, III The Presidency of Gerald Ford [John Robert Greene]: “The new mood in Capitol Hill made any kind of a coalition virtually impossible even for such an experienced legislative hand as Gerald Ford. More so than any other time since 1945, American government was truly divided...." I Class of 1974 Congressman. I Breakdown of old committee system. I Wilbur Mills’ car stopped on October 9, 1974. I Al Ullman is less powerful. I Humphrey-Javits act about indicative planning. FV-G-K-R Fiscal Volatility 16 / 45 The Congressman and the Argentine Firecracker FV-G-K-R Fiscal Volatility 17 / 45 Forecast dispersion: tax on capital income 0.5 0.45 0.4 0.35 0.3 0.25 0 10 20 FV-G-K-R Fiscal Volatility 30 40 18 / 45 Relation with other measures of uncertainty I How much do we believe our empirical results? I Bloom et al. (2014) measure uncertainty using news media coverage, tax provisions set to expire, and disagreement among forecasters. I Surprisingly high correlation of their uncertainty measure with our smoothed volatilities. I For instance, correlation of uncertainty with volatility of capital taxes: 0.56. FV-G-K-R Fiscal Volatility 19 / 45 Key ingredients I Representative household. I Labor supply flexible, but wages with quadratic adjustment cost. I Investment adjustment costs, but flexible utilization margin of capital. I Prices with quadratic adjustment cost. I Fiscal rules as discussed above+Taylor rule for monetary policy. FV-G-K-R Fiscal Volatility 20 / 45 Households I I Household maximizes: ( Z 1 l 1+ϑ ) ∞ 1−ω X (c − b c ) j,t t h t−1 −ψ dj E0 β t dt 1−ω 0 1+ϑ t=0 I Intertemporal shock dt : log dt = ρd log dt−1 + σd εdt , εdt ∼ N (0, 1) I Savings: 1. Invest, it . 2. Hold government bonds, Bt , with nominal gross interest rate Rt . FV-G-K-R Fiscal Volatility 21 / 45 Households II I Budget constraint: (1 + τc,t )ct + it + bt + Ωt + 1 − τl,t R1 0 0 ACj,tw dj = b + wj,t lj,t dj + 1 − τk ,t rk ,t ut kt−1 + τk ,t δkt−1 +bt−1 I R1 Rt−1 Πt + zt . Real wage adjustment costs for labor type j: ACj,tw = φw 2 2 wj,t − 1 yt wj,t−1 I Quadratic cost 6= Calvo. Remember: non-linear solution! I We also computed the model with Calvo pricing. FV-G-K-R Fiscal Volatility 22 / 45 Households III I Labor packer: 1 Z lt = w −1 w lj,t 0 ! w w −1 dj I Demand for each type of type of labor: wj,t −w lj,t = lt wt I By a zero-profit condition: Z wt = 0 FV-G-K-R 1 ! 1−w wj,t 1 1−w Fiscal Volatility 23 / 45 Households IV I Capital accumulation: where: I it it kt = (1 − δ(ut )) kt−1 + 1 − S it−1 1 δ(ut ) = δ + Φ1 (ut − 1) + Φ2 (ut − 1)2 2 Quadratic adjustment cost: 2 it it κ S = −1 it−1 2 it−1 which implies S(1) = S 0 (1) = 0 and S 00 (1) = κ. I Book value of capital: b ktb = (1 − δ)kt−1 + it FV-G-K-R Fiscal Volatility 24 / 45 Firms I I Competitive producer of a final good: 1 Z yt = ε−1 ε yit 0 ! ε ε−1 di I Buys intermediate goods at price Pi,t and charges Pt . I Demand: yit = I Pit Pt −ε yt Price index: Z Pt = 0 FV-G-K-R 1 ! 1 1−ε Pit1−ε di Fiscal Volatility 25 / 45 Firms II I Intermediate good producer with market power: yit = At kitα lit1−α − φ I At is neutral productivity: log At = ρA log At−1 + σA εAt , εAt ∼ N (0, 1) and ρA ∈ [0, 1) I Intermediate producer sets prices at cost: p ACi,t φp = 2 FV-G-K-R Pi,t −Π Pi,t−1 Fiscal Volatility 2 yi,t 26 / 45 Government I Monetary authority follows Taylor rule: Rt = R I Rt−1 R 1−φR Πt Π (1−φR )γΠ yt y (1−φR )γy eσm ξt Fiscal authority’s budget constraint: bt = bt−1 Rt−1 Πt b τ +gt − ct τc,t + wt lt τl,t + rk ,t ut kt−1 τk ,t − δkt−1 k ,t + Ωt I Transfers: Ωt = Ω + φΩ,b (bt−1 − b) where φΩ,b > 0. FV-G-K-R Fiscal Volatility 27 / 45 Aggregation and solution I Aggregate demand: φp φw yt = ct + it + gt + (Πt − Π)2 yt + 2 2 I 2 wt − 1 yt wt−1 Aggregate supply: yt = At (ut kt−1 )α lt1−α − φ I Market clearing. I Definition of equilibrium is standard. FV-G-K-R Fiscal Volatility 28 / 45 Estimation I General point: problems for calibration in non-linear models. I The Pruned State-Space System for Non-Linear DSGE Models: Theory and Empirical Applications. I We use a SMM to estimate most parameters. I Parameters for fiscal instruments laws of motion: median of our posteriors. I Third-order perturbation solution. Why? I Non-linear IRFs. Why? Details of the Estimation FV-G-K-R Fiscal Volatility 29 / 45 Experiment xt = ρx xt−1 + φx,y ỹt−1 + φx,b bt−1 yt−1 + exp(σx,t )εx,t (1/2) σx,t = (1 − ρσx ) σx + ρσx σx,t−1 + 1 − ρ2σx ηx ux,t I At time 0, the economy is hit by a fiscal volatility shock to capital income tax. I Taxes are constant today. I Two-standard deviation shocks to uk ,t . Meant to capture current fiscal outlook. Perotti (2007), Bloom (2009). FV-G-K-R Fiscal Volatility 30 / 45 Fiscal volatility shocks output cons. invest. hours 0 0 0 −0.5 −0.02 −0.05 −0.05 0 −1 −0.04 −0.1 10 −0.06 0 marg. cost 10 inflation (bps) 0 −0.06 0 10 0 0 10 0 nom. rate (bps) 10 wages 0 −0.02 20 20 −0.04 −1.5 0 40 40 −0.02 −0.1 −0.04 10 FV-G-K-R 0 0 −0.06 10 Fiscal Volatility 0 10 31 / 45 Fiscal volatility shocks (black solid) vs. 30bps monetary shock (red dots) output cons. 0.1 invest. hours 0.5 0.05 0 0 −0.1 10 marg. cost 0 10 inflation (bps) 0 −0.02 −0.04 −0.06 0 10 40 20 0 −20 −40 0 0 −0.1 −1 −0.05 −0.2 0 0 −0.5 −1.5 0 −0.2 10 nom. rate (bps) 40 FV-G-K-R 10 wages 0.05 20 0 0 −0.05 −20 0 10 0 10 Fiscal Volatility −0.1 0 10 32 / 45 VAR evidence: IRFs output 0.2 0 −0.2 −0.4 −0.6 0 consumption investment 0 0 −0.2 −2 −0.4 5 10 quarters 15 −0.6 0 5 10 quarters hours 15 −4 0 15 inflation (bps) markup 0.3 0.5 5 10 quarters 0 0.2 0.1 0 −20 0 −0.5 0 5 10 quarters 15 −0.1 0 nominal rate (bps) 20 0 −20 −40 −60 −80 0 −40 5 10 quarters 15 real wage 30 −0.2 20 −0.4 10 15 0 −0.8 15 5 10 quarters capital tax vola 0 −0.6 5 10 quarters 0 0 5 10 quarters FV-G-K-R −10 15 0 Fiscal Volatility 5 10 quarters 15 33 / 45 The effect of the ZLB output 0.1 0 −0.1 −0.2 −0.3 0 −1 −2 0 10 marginal cost 0.4 0.2 0 −0.2 −0.4 −0.6 0 cons. 0 0 0 −1 −5 −2 −10 0 10 inflation (bps) FV-G-K-R 0 10 wages 0.1 0 X: 1 Y: 0 0 10 10 nominal rate (bps) 800 600 400 200 0 −100 −150 0 hours 5 −50 10 invest. −0.1 10 Fiscal Volatility 0 10 34 / 45 Monetary policy output cons. invest. hours 0 0 0 0 −1 −0.05 −0.1 −0.1 −2 −0.2 0 10 marg. cost −0.1 0 10 inflation (bps) 0 0 10 nom. rate (bps) 10 wages 0 100 100 −0.05 −0.05 50 50 −0.1 −0.1 0 I Rt R −0.2 0 10 = Rt−1 R 0 0 1−φR 0 0 10 Πt Π 10 (1−φR )γΠ ↑=1.5 (1−φR )γy ↑=0.5 yt y FV-G-K-R Fiscal Volatility 0 10 eσm ξt 35 / 45 Degree of nominal rigidities output consumption investment hours 0 0 −0.05 −0.1 0 −0.04 10 0 marginal cost 0 −0.2 −0.4 −0.6 −0.8 −1 −1.2 −0.02 10 −0.05 −0.1 0 inflation(bps) 10 0 nominal rate(bps) 0 10 wages 40 40 0 20 20 −0.05 −0.02 −0.04 −0.06 0 −0.08 0 I I I 10 0 0 0 10 10 −0.1 0 10 blue: (Calvo) φp = 0.1 red: (Calvo) φw = 0.1 magenta: (Calvo) φp = 0.1 and φw = 0.1 FV-G-K-R Fiscal Volatility 36 / 45 The role of precautionary price setting output cons. invest. hours 0 0.05 0.05 −0.5 −0.02 0 −0.05 0 −0.05 −0.04 −1 −0.06 0 −1.5 0 −0.1 −0.1 0 10 marg. cost infl. 40 −0.05 10 0 0 0 10 wages 0 −0.02 20 20 0 10 nom. rate 40 0.05 0 10 −0.04 10 FV-G-K-R 0 0 −0.06 10 Fiscal Volatility 0 10 37 / 45 The future I So far, I have dealt with two-sided risk. I This may not capture what many observers have in mind: one-sided risk. For instance, taxes will increase, but we do not know why how much. I A simple alternative: innovation to shock+volatility shock. I A more appealing alternative: one-sided risk. I Formally: shocks to skewness. I One-Sided Risk and Economic Activity (2014). FV-G-K-R Fiscal Volatility 38 / 45 One-side risk I Stochastic process: xt = ρxt−1 + (1 − ρ)υt + (1 − ρ2 )(1/2) eτt ωt + (1 − ρ)eαt ξt1 − (1 − ρ)eβt ξt2 where υt = (1 − ρυ )υ + ρυ υt−1 + ηυ (1 − ρ2υ )(1/2) ε1t τt = (1 − ρτ )τ + ρτ τt−1 + ητ (1 − ρ2τ )(1/2) ε2t αt = (1 − ρα )α + ρα αt−1 + ηα (1 − ρ2α )(1/2) ε3t βt = (1 − ρβ )β + ρβ βt−1 + ηβ (1 − ρ2β )(1/2) ε4t ωt ∼ N (0, 1), ξti ∼ exp (1) , εjt ∼ N (0, 1) FV-G-K-R Fiscal Volatility 39 / 45 Conclusion I High fiscal volatility is a concern for policymakers. I But, how big are the effects of fiscal volatility shocks? I Our simulations indicate that the effect can be important. I Key role for monetary policy in propagation. I Modeling of political-economic equilibrium that leads to these shocks remains an open issue. FV-G-K-R Fiscal Volatility 40 / 45 Estimated parameters Tax rate on Labor ρx σx φx,y φx,b ρσx ηx Government Consumption Capital Spending 0.99 0.99 0.97 0.97 [0.975,0.999] [0.981,0.999] [0.93,0.996] [0.948,0.992] −6.01 −7.09 −4.96 −6.13 [−6.27,−5.75] [−7.34,−6.78] [−5.29,−4.66] [−6.49,−5.39] 0.031 0.001 0.044 −0.004 [0.011,0.055] [0.000,0.005] [0.004,0.109] [−0.02,0.00] 0.003 0.0006 0.004 −0.008 [0.00,0.007] [0.00,0.002] [0.00,0.016] [−0.012,−0.003] 0.31 0.65 0.76 0.93 [0.06,0.57] [0.08,0.91] [0.47,0.92] [0.43,0.99] 0.94 0.60 0.57 0.43 [0.73,1.18] [0.31,0.93] [0.33,0.88] [0.13,1.15] Notes: The posterior median and a 95% probability interval. I Persistent mean-dynamics. I Stochastic volatility is significant and moderately persistent. Return FV-G-K-R Fiscal Volatility 41 / 45 Estimation I Preferences and consumer β 0.9945 ω 2 Standard choice. ϑ 2 Chetty (2011). ψ 75.66 bh 0.75 CEE (JPE, 2005). φw 4889 ACEL (RED, 2011). 21 ACEL (RED, 2011). Estimated. Estimated. Cost of utilization and investment Φ1 0.0165 From utilization FOC. Φ2 0.0001 Estimated. 3 Estimated. κ FV-G-K-R Fiscal Volatility 42 / 45 Estimation II Firms A 1 α 0.36 δ 0.011 φp 236.10 w 21 Normalization Standard choice. Estimated. Gali and Gertler (JME, 1999). ACEL (RED, 2011). Monetary policy and lump-sum taxes 1.0045 Estimated. φR 0.6 Estimated. γΠ 1.25 FGR (2010). γy 1/4 FGR (2010). Ω -4.3e-2 Follows from gov. budget constraint. φΩ,b 0.0005 Small number to stabilize debt. Π b 2.64 Estimated. FV-G-K-R Fiscal Volatility 43 / 45 Estimated III Shocks I ρA 0.95 King and Rebelo (1999). σA 0.001 ρd 0.18 σd 0.078 Estimated. σm 0.0001 Estimated. Estimated. Smets and Wouters (AER, 2007). Parameters for fiscal instruments laws of motion: median of our posteriors. Return FV-G-K-R Fiscal Volatility 44 / 45 Decomposing fiscal volatility shocks output cons. invest. hours 0.02 0.2 0 −0.2 −0.4 −0.6 0 0 −0.1 −0.02 −0.2 0 10 20 0 marg. cost 10 20 inflation(bps) 40 −0.02 0 −0.1 0 10 20 nominal rate(bps) 10 20 wages 20 0 10 −0.01 20 0 −0.04 −0.06 0 −0.2 0 −0.02 0 10 20 −20 0 −10 10 20 0 10 20 −0.03 0 I black: benchmark. I red: volatility shock only on capital income taxes. FV-G-K-R Fiscal Volatility 10 20 45 / 45